5 Things Your Financial Statements Won't Tell You

Business Management
January 03, 20235 min read

Read the annual financial statements of a large company like Tesla and you'll find surprisingly few pages devoted to actual numbers. Instead, the pages are filled with "disclosures" that describe every future problem Tesla's managers (or rather, its auditors!) could imagine. Pessimism and uncertainty often drip from the pages.

In contrast, let's say you own a 10-person construction company with sales of $5 million. Your year end reports consist of a simple balance sheet and income statement - maybe 3 or 4 pages total. The reports show $300,000 in profit, assets worth $600,000, and debts of $200,000. It's all numeric. There are no disclosures.

As a naturally skeptical entrepreneur you wonder, What am I missing? If my reports had disclosures like Tesla, what would they say?

Here are five key items you won't find on most small-company financial reports.

1. Income Taxes

As an avid member of BYO CFO, you know by now that most small, privately-owned businesses are set up for tax purposes as one of these three entity types:

  1. Sole proprietorship.

  2. Partnership.

  3. S Corporation.

These are all "pass-through" entities which means business profit is "passed through" to the owner. Any income tax due on that profit is paid on the owner's personal tax return.

Accordingly, in the construction example above, the $300,000 profit does not include a deduction for income taxes. If the owner owes $90,000 in taxes on that profit, the business really only made $210,000.

There is an even deeper twist to this point. Many small businesses file their taxes on the cash basis, but run QuickBooks on the accrual basis. Without getting into the technicalities of the difference, this usually means QuickBooks consistently shows more profit than the company's tax return.

There is nothing inherently wrong with this, but it is important to know that tax chickens always come home to roost. If you defer taxes for many years and then exit your ownership in the company, the deferred tax is generally due upon exit.

A few years ago I worked with an entrepreneur who sold his company after years of deferring taxes. After he paid the taxes due on the sale, there was basically no money left. Again, there was nothing wrong with this. It was simply a reminder that hidden tax "debt" existed on his company's balance sheet. This point is true for most privately-owned companies.

This missing tax line is important to consider when valuing your company or calculating the true equity in your business.

2. Inventory

A few years ago I worked with a farm that showed an impressive profit. The next year, though, profits tanked.

The backstory was that the "good" year had actually been a bad year for raising hay. However, the shortage of hay did not become painful until spring of the next year when the hay ran out. At that point, the farm had to buy supplemental hay at high rates, which lowered the profits in the "bad" year.

Ironically, as I recall, the crops were good in the bad year, which helped make the next year good!

Especially in certain industries, problems with inventory may be obscured in current year numbers. The obscured problem could be critically low stock levels, as in the farm example. Or, it could be that in the current year the company had access to large quantities of cheap inventory, but that opportunity is not available next year.

In either case, the straight numbers will not tell these stories. It's up to you to consider and mentally adjust the numbers as needed.

3. Backlog

Which position would you rather be in?

  1. $300,000 in profit for 2022. $1,000,000 of orders on the books for next year.

  2. $100,000 in profit for 2022. $5,000,000 of orders on the books for next year.

Assuming equivalent profit margins, most entrepreneurs would choose Scenario 2. There's nothing scarier than running out of work. A good year is meaningless if a very bad year is ahead.

Audited financial statements for project-based companies (e.g. construction companies) often include a note about the company's backlog of work. That's because you can't get a sense for it simply by looking at the current year financials.

4. Customer Concentration

Which position would you rather be in?

  1. $300,000 in profit for 2022. All earned from one big customer.

  2. $150,000 in profit for 2022. Earned from 100 small customers scattered across the US.

Again, most entrepreneurs would choose Scenario 2. To continue with chicken analogies, everyone knows you "don't put all your eggs in one basket." A good year that hinges on a relationship with one critical customer is not exactly a banner year.

I always push hard to see detailed profit reports by customer that tie to the main income statement. For example, if the overall income statement shows $300,000 of profit, the profit by customer report needs to add up to $300,000 as well. Otherwise the detailed reports are basically useless.

5. Interest Rates

This final point is new for 2022, and is one of the most important items missing from a balance sheet.

Here are two more scenarios:

  1. $200,000 profit for 2022. $2,000,000 of debt locked at 4% interest for 7 years.

  2. $250,000 profit for 2022. $2,000,000 of debt locked at 4% interest for 6 months.

All things equal, Scenario 1 is likely the better option. Interest is locked at $80,000 per year for 7 years. In Scenario 2, the interest rate will likely reset at 7% ($140,000 per year) or higher next June. Unless interest rates fall again, this extra $60,000 expense will hit the company in Scenario 2 every year for seven years.

I can't believe this topic hasn't gotten more traction in the business press. Most commercial loans are currently locked at low rates that will reset in the next 1 to 5 years. When that happens, the impact on profitability will be enormous. Companies with long-term fixed lower rates will be at a distinct advantage.

Interest rates and terms aren't shown on the average balance sheet. An astute financial statement reader needs to look "beyond the numbers" to see it.

Scott Hoover

Back to Blog

Be Your Own

5 Things Your Financial Statements Won't Tell You

Business Management
January 03, 20235 min read

Read the annual financial statements of a large company like Tesla and you'll find surprisingly few pages devoted to actual numbers. Instead, the pages are filled with "disclosures" that describe every future problem Tesla's managers (or rather, its auditors!) could imagine. Pessimism and uncertainty often drip from the pages.

In contrast, let's say you own a 10-person construction company with sales of $5 million. Your year end reports consist of a simple balance sheet and income statement - maybe 3 or 4 pages total. The reports show $300,000 in profit, assets worth $600,000, and debts of $200,000. It's all numeric. There are no disclosures.

As a naturally skeptical entrepreneur you wonder, What am I missing? If my reports had disclosures like Tesla, what would they say?

Here are five key items you won't find on most small-company financial reports.

1. Income Taxes

As an avid member of BYO CFO, you know by now that most small, privately-owned businesses are set up for tax purposes as one of these three entity types:

  1. Sole proprietorship.

  2. Partnership.

  3. S Corporation.

These are all "pass-through" entities which means business profit is "passed through" to the owner. Any income tax due on that profit is paid on the owner's personal tax return.

Accordingly, in the construction example above, the $300,000 profit does not include a deduction for income taxes. If the owner owes $90,000 in taxes on that profit, the business really only made $210,000.

There is an even deeper twist to this point. Many small businesses file their taxes on the cash basis, but run QuickBooks on the accrual basis. Without getting into the technicalities of the difference, this usually means QuickBooks consistently shows more profit than the company's tax return.

There is nothing inherently wrong with this, but it is important to know that tax chickens always come home to roost. If you defer taxes for many years and then exit your ownership in the company, the deferred tax is generally due upon exit.

A few years ago I worked with an entrepreneur who sold his company after years of deferring taxes. After he paid the taxes due on the sale, there was basically no money left. Again, there was nothing wrong with this. It was simply a reminder that hidden tax "debt" existed on his company's balance sheet. This point is true for most privately-owned companies.

This missing tax line is important to consider when valuing your company or calculating the true equity in your business.

2. Inventory

A few years ago I worked with a farm that showed an impressive profit. The next year, though, profits tanked.

The backstory was that the "good" year had actually been a bad year for raising hay. However, the shortage of hay did not become painful until spring of the next year when the hay ran out. At that point, the farm had to buy supplemental hay at high rates, which lowered the profits in the "bad" year.

Ironically, as I recall, the crops were good in the bad year, which helped make the next year good!

Especially in certain industries, problems with inventory may be obscured in current year numbers. The obscured problem could be critically low stock levels, as in the farm example. Or, it could be that in the current year the company had access to large quantities of cheap inventory, but that opportunity is not available next year.

In either case, the straight numbers will not tell these stories. It's up to you to consider and mentally adjust the numbers as needed.

3. Backlog

Which position would you rather be in?

  1. $300,000 in profit for 2022. $1,000,000 of orders on the books for next year.

  2. $100,000 in profit for 2022. $5,000,000 of orders on the books for next year.

Assuming equivalent profit margins, most entrepreneurs would choose Scenario 2. There's nothing scarier than running out of work. A good year is meaningless if a very bad year is ahead.

Audited financial statements for project-based companies (e.g. construction companies) often include a note about the company's backlog of work. That's because you can't get a sense for it simply by looking at the current year financials.

4. Customer Concentration

Which position would you rather be in?

  1. $300,000 in profit for 2022. All earned from one big customer.

  2. $150,000 in profit for 2022. Earned from 100 small customers scattered across the US.

Again, most entrepreneurs would choose Scenario 2. To continue with chicken analogies, everyone knows you "don't put all your eggs in one basket." A good year that hinges on a relationship with one critical customer is not exactly a banner year.

I always push hard to see detailed profit reports by customer that tie to the main income statement. For example, if the overall income statement shows $300,000 of profit, the profit by customer report needs to add up to $300,000 as well. Otherwise the detailed reports are basically useless.

5. Interest Rates

This final point is new for 2022, and is one of the most important items missing from a balance sheet.

Here are two more scenarios:

  1. $200,000 profit for 2022. $2,000,000 of debt locked at 4% interest for 7 years.

  2. $250,000 profit for 2022. $2,000,000 of debt locked at 4% interest for 6 months.

All things equal, Scenario 1 is likely the better option. Interest is locked at $80,000 per year for 7 years. In Scenario 2, the interest rate will likely reset at 7% ($140,000 per year) or higher next June. Unless interest rates fall again, this extra $60,000 expense will hit the company in Scenario 2 every year for seven years.

I can't believe this topic hasn't gotten more traction in the business press. Most commercial loans are currently locked at low rates that will reset in the next 1 to 5 years. When that happens, the impact on profitability will be enormous. Companies with long-term fixed lower rates will be at a distinct advantage.

Interest rates and terms aren't shown on the average balance sheet. An astute financial statement reader needs to look "beyond the numbers" to see it.

Scott Hoover

Back to Blog

Scott Hoover, CPA

About The Author:

Scott lives in Wisconsin with his wife Priscilla and their active family of eight children. 

He has worked as a CPA and part-time CFO for over a decade, and draws on this experience to provide practical, down-to-earth guidance to his clients.

In addition to his CPA day job, he and his family have a small farm where they raise calves and produce.  In his "spare" time, Scott enjoys writing articles on finance and faith.

Send any comments or feedback directly to scott@beyourowncfo.com.

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